Chapter 6

International Fischer Effect (Interest rate model): explains how the exchange rate is determined by interest rate differential

• goal is to determine future exchange rate

Inflation model or PPP model

• goal is to determine future exchange rate

Spot exchange rate

Future exchange rate

Inflation rate

Percentage change over time in both models

Place target currency on the bottom side

Euro with lower interest rate is expected to ________

Appreciate

The force that causes the spot rate to change according to the IFE is actually inflation

IFE: Assume that the spot exchange rate of the Singapore dollar is $.70/S$. The one-year interest rate is 11 percent in the United States and 7 percent in Singapore. What will the spot rate be in one year according to the IFE?

The Singapore dollar is expected to appreciate by 4 percent

What is the force that causes the spot rate to change according to

the IFE?

– Inflation!

The Fisher effect presume that the nominal interest consists of two components:

1) the expected inflation rate and

2) the real rate of interest

(1+Nominal Interest Rate)

= (1+Real Interest Rate) x (1+Expected Inflation Rate)

Nominal Interest Rate ≈ (Real Interest Rate + Inflation)

Assume that the real interest rates between two countries are the same

Why is there issues with PPP?

• restrictions on movements of goods

• tariffs

• short term violations of the law

How well does IFE hold